Behavioral Economics and Game Theory

INTRODUCTION

Behavioral Economics

“At the core of behavioral economics is the conviction that increasing the realism of the psychological underpinnings of economic analysis will improve economics on its own terms -- generating theoretical insights, making better predictions of field phenomena, and suggesting better policy.” --Colin F. Camerer, Behavioral Economics: Past, Present, Future

Traditional economists adhere to Homo economicus and believe that all humans are rational actors who make decisions based on their own well being. Although this belief if convenient for economic modeling, there is evidence that suggests otherwise. Behavioral economics is a discipline which tries to understand and model human decision making through cognitive-psychology. This field is primarily concerned with the bounded rationality of economics agents, and why and how they make decisions. Although homo economicus serves as a coherent framework to model human behavior, behavioral economists argue that actual human behavior deviates from this rational model in predictable way and by incorporating these features into economic models, it would improve our ability to explain observed behavior. (2)

Perhaps the greatest challenge facing behavioral economics is demonstrating its applicability in the real world. In nearly every instance, the strongest empirical evidence in favor of behavioral anomalies emerges from the lab. Yet, there are many reasons to suspect that these laboratory findings might fail to generalize to real markets. (2)

Recently, with the development of neuroeconomics, researchers have begun to apply fMRI imaging to their subjects to observe what is going on in the brain while decisions are being made.

Game Theory

Game theory is a tool that is used to address social and economic problems. It is the study of strategic interactions among rational players to produce outcomes with respect to the preferences or utilities of those players, which may not have been intended by any of them. In a game, several agents strive to maximize their own utility by choosing particular courses of action, and each agent's final utility payoffs depend on the profile of courses of action chosen by all agents. Economists use game theory to capture an abundance of economic phenomena in order to better understand how economic actors make decisions. It is usually highly mathematical and bases on introspection and guesses rather that careful observation of how people actually play the games. (1)

A game-theoretical model of behavior requires a description of the people in the game, the information each player has, their actions, and the expected payoff from each strategy. A Nash equilibrium of a game identifies an optimal strategy as long as every player bahaves optimally.(5)

The power of game theory is in its generality and mathematical precision and the same basic principles are used to analyze all game. Although there are clear examples of some of the most prominent games listed below, it can be applied to a variety of situations. (1) For example, say you are walking on a beach in Mexico and you see a vendor selling handmade bracelets with your name on them. Let’s assume they are worth anywhere between $10- $20 to you, and the vendor knows how impatient most tourists are but isn’t sure how much you value the bracelets. Game theory can tell you exactly what price the vendor should start out at and how quickly he should cut the prices that when you haggle with him.

GAMES

The Ultimatum Game

The Ultimatum Game is one in which two players anonymously interact to decide how to divide a sum of money that is given to them. The first player makes a proposal to divide a sum between themselves, and the second player can either accept or reject this proposal. If the second player rejects, neither player receives anything. If the second player accepts, the money is split according to the proposal.

Alan Sanfey and his colleagues modified the Ultimatum Game to generate only the following X1-X2 offers: {5,5}, {7,3}, {8,2}, and {9,1}. In their study, only the X2s were scanned and the X1 was played by a computer. The researchers deceived the X2s into believing they were playing against another person in order to simply protocol. Some X2 were told they were playing against a computer to obtain a control group. Unfair offers activated three distinct areas of the brain, the anterior insula, the dorsolateral prefrontal cortex, and the anterior cingulate cortex. Activation in these areas was also greater for unfair offers from humans than from a computer. Based on other previous neurological evidence, Sanley et al. concluded that low offers in this game are rejected because they trigger a sense of disgust within the brain.(5)

Trust Game

The Trust Game is an extension of the Dictator Game, which is a simple version of the Ultimatum Game where the proposer gets to keep the money no matter what the outcome. Kevin McCabe and his colleagues we able to provide an incentive for cooperative behavior by using a binary choice version of the Trust Game, where subjects can earn more money if they cooperate, but cannot communicate except by transferring money to each other through choices. Subjects X1 and X2 made sequential choices for the dollar amounts. X1 makes the first decision and can end the interaction immediately and provide payoffs of 45 for each (moving left in the figure) or transfer control over to X2 (moving right). By yielding control, X1 signals trust in X2. X2 can either be trustworthy and earn 180 for X1 and 225 for X2 or untrustworthy and earn 405 while X1 will earn nothing. The researchers found that a particular part of the brain (BA10) becomes more active when subject were not cooperative and relative to a control task where subjects were interacting with a computer that moved based with known probabilities. McCabe et al. argue that BA10 is part of the neural architecture that allows gratification delay in order to obtain larger rewards. The authors concluded that cooperation is rewarding, requires attention and mediation of the conflicting concerns of making more money in a socially unacceptable way (being untrustworthy), and has an emotional component. (5,4)

SOURCES

1. Camerer, C.F. Behavioral Game Theory:Experiments in Strategic Interaction. Princeton University Press, 2003

2. Levitt, S.D. and J.A. List. "Homo economicus Evolves." Science. February 2008: Vol. 319. no. 5865, pp. 909 - 91

3. McCabe et al. "A Functional Imaging Study of Cooperation in Two-person Reciprocal Exchange." Proceeding of the National Academy of the Sciences http://mason.gmu.edu/~dhouser/functional.pdf

4.Sanley et al "The Neural Basis of Economic Decision-making in the Ultimatum Game" Science. June 2003: Vol. 300. no. 5626, pp. 1755 - 1758

5. Zak, P.J. "Neuroeconomics." The Royal Society Published online 26 Nov. 2004